Inflation is the rate at which relative prices for goods and services increase. At first, this sounds like a simple concept, but actually it is rather complex. Inflation affects numerous aspects of the market and many factors influence it. Inflation is measured using several different price sources, with the Consumer Price Index (CPI) and the Producer Price Index (PPI) being two of the core metrics. The CPI measures the price changes in consumer goods and services. Prices on goods like cars, clothing and food are measured from the purchaser’s point of view. The PPI measures the price changes in goods and services by domestic producers from the seller’s viewpoint.
If prices go up, the current value of the currency is eroded. What could have been purchased a year prior for RM1.00 might now cost RM1.20, and if salaries had not risen in tandem with this inflation, the public would have lost purchasing power. From this vantage point, some may see inflation as a bad thing. However, the right balance of inflation and economic growth is important for a healthy economy. An economy that grows too fast can cause high rates of inflation and an economy with slow or no growth can cause low levels of inflation or even deflation (when prices decline). Inflation is one of several key factors that are considered when interest rates are set by a central bank. Interest rates determine the cost of borrowing and dictate savings, mortgage, and car loan rates, among others (see Exhibit 1 for U.S. inflation and interest rates).
In general, economies are expected to grow—not stay the same or slow down. A growing economy (possibly caused by low interest rates) can cause inflation, as consumers in these economies typically feel confident about the future and spend more money. Sellers anticipate this demand and raise prices, creating inflation. This is also known as “demand-pull” inflation. When supply is not keeping up with demand, prices can become even higher. If consumers expect further inflation in the future, they may make purchases sooner in order to avoid higher prices down the road, which in turn benefits economic growth.
In contrast, inflation can occur even without economic growth. An increase in the cost of business can cause inflation as well. If manufacturers slow output while demand remains the same, then prices will go up as a result of basic supply and demand principles. Manufacturers could slow down due to higher wages, new taxes or an increase in the cost of exports (foreign exchange or FX cost). This is known as “cost-push” inflation.
The rate of inflation influences the direction of interest rates and, conversely, interest rates influence the direction of inflation.
Expansion in the money supply is another major cause of inflation. This occurs when the government or central bank introduces additional money into the economy to spur spending and growth, but the level of production of goods and services remains constant. More money in the economy generally causes increased demand, and this demand chases the same amount of goods. Therefore, prices go up in order to avoid a shortage of supply. In this scenario, inflation erodes the value of money and purchasing power decreases.
A government can also add money into the economy through the purchase of bonds in the marketplace, which is commonly called quantitative easing (QE). The goal of QE is to inflate prices of bonds so that yields decline, consequently keeping rates low to spur easy lending and growth in the economy.
The rate of inflation influences the direction of interest rates and, conversely, interest rates influence the direction of inflation. If inflation is high, interest rates will typically be raised by the central bank to slow economic growth. If inflation is low, economic growth is generally low, and a decrease in rates is enacted in order to lower the cost of borrowing and to spur economic growth. More borrowing power can lead to spending, a stronger economy and, ultimately, inflation. The central bank has the task of finding the right balance of tweaking interest rates to manage growth and keep unemployment low and wages high. The Federal Reserve also has to avoid promoting too much growth, which could lead to high inflation. Generally, a central bank tries to keep inflation within the 2%-3% range.
When interest rates are increased to tame inflation, foreign capital is usually attracted to the higher rates compared with other countries, and there is more investment in the higher rate environment. This causes the exchange rate to rise. However, if inflation is high (diminishing the purchasing power of that currency), the rise of the currency could be limited. If rates go lower, the opposite is generally true and the currency is likely to suffer (see Exhibit 2)
Source: S&P Dow Jones Indices LLC. For
illustration only
Although the above diagram simplifies things, other reasons for exchange rate fluctuations include:
• Trade balances (surplus/deficits);
• Capital flows (inflows/outflows);
• Speculators who create “artificial” demand/supply;
• Productivity improvements (or otherwise);
• Forex reserves of the central bank;
• Private/public investments; and
• Relative GDP growth
For us to reach parity with the Singapore dollar, there are a whole range of changes required. But that is unlikely in the current political climate. Meanwhile, inflation could be described as a monetary phenomenon as much as a cost-push issue arising from supply disruptions. Whatever the case, the poor and wage earners are impacted by rising prices unless the Government works-out short-term and long-term measures soon.
References:
Where inflation and interest rates intersect, Heather McArdle, S&P Dow Jones Indices
BNM Annual Reports
The Malaysian Economy in Figures, EPU
Trading Economics (www.tradingeconomics.com)
No comments:
Post a Comment